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The Journal of American Academy of Business, Cambridge * Vol. 19 * Num. 2 * March 2014 88
Stock Price Volatility and Firm Capital Structure Decisions during
the Financial Crisis
Dr. Deniz Ozenbas and Dr. Luis San Vicente Portes, Montclair State University, Montclair, NJ

ABSTRACT

Financial economics research establishes that there is a link between the stock price volatility of a firm and
its capital structure decisions. We hypothesize that this relationship would become especially critical during periods
of stress such as periods with heightened stock price volatility and diminished opportunities of debt financing (i.e.
during a credit crunch). Towards that end, in this study we build on our previous theoretical and empirical work
about the relationship between stock price volatility and capital structure at the firm level by specifically
investigating the capital structure decisions and borrowing costs of publicly traded firms during the most recent
financial crisis, i.e. 2007-2009. To account for possible systematic differences between smaller and larger firms
(such as credit constraints, or credit market frictions) we analyze different size firm-groups based on their market
capitalization. Through quartile regressions, we analyze the relation between firm risk and the debt ratios and the
cost of external financing across the distribution of firms. We frame our analysis based on the Financial Accelerator
Model of Bernanke et. al (1999). Since the effect of heightened risk on leverage is offset during investment booms,
we propose that in a crisis period that directly follows a boom firms will be even more adversely affected due to
their heightened levels of leverage, and the above described relationship will be more pronounced. Finally, we
distinguish between financial and non-financial firms in order to identify the strength of such propagation
mechanisms and hence would be able to provide policy recommendations for financial services regulation. This
distinction proves crucial since we find fundamental differences between financial and non-financial firms in terms
of their capital structure, and ability to borrow, where the former are more leveraged and exhibit lower cost of
capital. Central to the analysis is the financial crisis and its disruptive effects. In the midst of the crisis, financial
firms lower cost of funding advantage is reversed for middle-sized firms. In other words, during that time non-
financial mid-size firms had lower cost of external capital than financial mid-size firms.

INTRODUCTION

The recent financial crisis was characterized by both extreme stock price volatility and a credit crunch as
the debt markets dried in response to the uncertainty in the market, especially in the aftermath of the Lehman
Brothers bankruptcy. It is established in the financial economics research that there is a link between the stock price
volatility of a firm and its capital structure decisions as the firms try to steer away from debt during such periods
(e.g.San Vicente Portes and Ozenbas, 2009). In this study, we investigate this relationship and hypothesize that it
becomes especially critical during periods of stress with both heightened stock price volatility and diminished
opportunities of debt financing (i.e. during a financial crisis).

Towards that end, we specifically investigate the capital structure decisions and borrowing costs of publicly
traded firms during the 1985 to 2009 period, and we specifically isolate the recent financial crisis period, i.e. 2007-
2009, to analyze the patterns of this period. We frame our analysis on the Financial Accelerator Model of Bernanke
et. al (1999). Since the effect of heightened risk on leverage is offset during investment booms, we propose that in a
crisis period that directly follows a boom firms will be even more adversely affected due to their heightened levels
of leverage, and the above described relationship will be more pronounced. Moreover, this effect is expected to be
larger in small and medium sized firms due to their lesser access to the credit markets, revealing financial
accelerator like effects.

One contribution of this study is to account for possible systematic differences between smaller and larger
firms (such as credit constraints, or credit market frictions) in their financing choices during a crisis as we analyze
different size firm-groups separately based on their market capitalizations. The importance of firm size in that firms
financing decisions is established in the academic literature, and we are contributing to this body of work by
specifically investigating the financial crisis period and measuring its impact on the borrowing costs and capital
structure decisions of firms of varying size groups. Another contribution is to measure the impact of extreme stock
volatility on the borrowing and capital costs of firms, again during the financial crisis period.

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Since we distinguish between financial and non-financial firms when comparing the strength of the
propagation mechanism between the economic crisis and the credit market, our findings have implications for policy
recommendations for financial services regulation. This distinction proves crucial since we find fundamental
differences between financial and non-financial firms in terms of their capital structure, and ability to borrow, where
the former are more leveraged and exhibit lower cost of capital throughout the sample. However, in the midst of the
crisis such cost of funding advantage for financial firms was reversed for middle-sized firms. In other words, during
that time non-financial mid-size firms had lower cost of external capital than financial ones, reflecting the level of
distress experienced in financial markets. Indirectly we also find evidence of deepening economic integration as
there is a small increase in geographic segments served, particularly amongst the largest firms.

LITERATURE REVIEW AND CONCEPTUAL BACKGROUND

There are several studies that investigate the volatility of the aggregate economy, the volatility of individual
firms (idiosyncratic risk) and the relationship between leverage and volatility. For example, Kim and Nelson (1999),
McConnell and Perez-Quiros (2000), and Blanchard and Simon (2001) are among others who investigate the
volatility of U.S. output growth and find that the aggregate output volatility has declined nearly by half over the last
40 years in the US economy. This trend is called the Great Moderation.

Firm-level (idiosyncratic) risk, on the other hand, has more than doubled since the 1960s while market risk
has remained unchanged during the same period according to Campbell et al. (2001) and Xu and Malkiel (2003)
among other researchers. Chaney, Gabaix and Philippon (2002), Comin and Mulani (2003), and Comin and
Philippon (2005) explore additional dimensions for which firm-specific volatility has increased and find that parallel
to the increase in volatility in firm-level stock market returns, firm-specific sales, employment and earnings have
also become more volatile during the same period.

Empirical corporate finance literature generally agrees that leverage decreases with increased volatility.
Bradley, J arrell, and Kim (1984), Friend and Hasbrouck (1988) and Friend and Lang (1988) are some important
studies that show this relationship. For example, Bradley, J arrell, and Kim (1984) show that firm leverage ratios are
inversely related to earnings volatility using cross-sectional, firm-specific data.

To assess the effect of larger firm-specific risk on the volatility of GDP growth we use Bernanke, Gertler
and Gilchrists (1999) financial accelerator framework. The financial accelerator is a propagation mechanism built
into a general equilibrium model in which the firms' ability to borrow depends on their net worth. Higher net worth
is associated with lower external-finance premium on the firms' debt, which used in combination with net worth to
fund their operations. The financial accelerator is a mechanism that amplifies aggregate shocks to the economy as it
generates an endogenous countercyclical external-finance premium.

The theoretical implementation of the model within a New Keynesian framework can be found in San
Vicente Portes and Ozenbas (2009)). In this study we provide an empirical assessment of the effect of higher
idiosyncratic risk on that firms capital structure decisions and the firms borrowing rates, during the recent financial
crisis. We perform this analysis separately for firms that belong to different size groups according to their market
capitalizations.

In general, the theoretical mechanism suggests that when firms are subject to both idiosyncratic and
aggregate shocks, the firms capital structure is determined endogenously as a function of both sources of shocks.
Moreover, in the presence of credit market imperfections, such as costly verification of returns by financial
intermediaries, the MM theorems no longer hold and the firms cost of borrowing depends on their collateral; that is,
their equity, and thus the individual firms capital structure has economy-wide implications as credit cycles amplify
the business cycle (i.e. the Financial Accelerator).

Within such framework, the observed trend in firm-level risk is modeled as a mean-preserving spread in the
distribution of idiosyncratic shocks. In the model, as the variance of firm-specific shocks increases firms revise their
capital structure, since all else equal, external financing costs increase as the perception of risk rises. Then, to
counteract the credit markets need for higher returns firms de-leverage, which in turn raises their collateral. This
way the Financial Accelerator is dampened as the firms net worth increases, and hence the economy goes through
smoother cycles.

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These theoretical predictions are supported empirically in a sample of public companies in Ozenbas and
San Vicente Portes (2010). This paper, in turn, seeks to analyze how the above described predictions of this
mechanism functioned during the recent financial crisis. As discussed below, during the financial crisis financial
accelerator-like effects were amplified and in some cases fundamental differences between financial and non-
financial firms were blurred or even reversed concerning the firms ability and cost of raising capital; where mid-
sized non-financial firms experienced lower costs of funding than mid-size financial firms.

DATA AND EMPIRICAL RESULTS

We study a sample of 500 publicly traded large-capitalization and mid-capitalization stocks between the
years of 1985 and 2009. We collect our stock price data from the CRSP database and our financial statements data
from the COMPUSTAT database. For each of the firms in our sample in addition to the daily stock price data we
also collect data about the debt, equity and liabilities of the firm, its short term borrowing rate, its international reach
(measured by the geographic segments in which they operate), and whether the firm belongs to the financial services
industry or not.

In Table 1a we present the summary statistics for our sample data. The four quartiles divide the sample data
into four groups based on the size of the company, with quartile 1 including the smallest 25% of the firms and
quartile 4 including the largest 25% of the firms. The debt to assets ratio of financial firms is higher for all quartiles
compared to the non-financial firms in our sample. Similarly, the short term borrowing rate of financial firms is
consistently smaller than the short term borrowing rate of non-financial firms. We also find that the standard
deviation of stock price returns is relatively similar when comparing financial and non-financial firms within each
quartile, except for the largest firms where we observe a higher standard deviation for financial firms indicating that
they as a group had higher stock price risk. As expected, small firms have a higher standard deviation compared to
larger firms. We also find that larger financial and non-financial firms operate in more geographic segments
compared to smaller firms, and within each quartile the geographic diversification of financial firms is slightly
higher than non-financial firms.

Table 1b we present the corresponding data during the financial crisis years. Since that subsample
corresponds to later years the average firm size in each quartile is larger than in the whole sample. Apart from that,
two features stand out. The first is the heightened idiosyncratic volatility, as measured by the standard deviation of
returns for all sectors and firm sizes. The second, as mentioned before, is the reversal in financial firms advantage
in raising external funding. For the second and third quartiles non-financial firms exhibit lower short term borrowing
rate than those in the financial sector. The findings show that debt to assets ratios of financial firms are higher than
non-financial firms similar to the findings of the whole sample period presented in table 1a. Also, the numbers for
geographic diversification is pretty comparable to the whole sample years of 1985-2009.

In Table 2 we present the simple regressions where the independent variable is the stock price volatility
(idiosyncratic risk) and the dependent variable is debt in liabilities/assets in Panel A, equity/assets in Panel B, short
term borrowing rate in Panel C, and long term debt/assets in Panel D. The regressions are run for all firms in our
sample during the entire study period. As we expected, both the debt in liabilities/assets ratio and the long term
debt/assets ratio is decreasing with stock price volatility as the firms try to deleverage during periods of accentuated
stock price volatility. We find that equity/assets ratio is increasing with stock price volatility, as is expected due to
decreasing debt/assets ratios. Finally, we find that the short term borrowing rate decreases since companies with less
leverage qualify for more advantageous (lower) borrowing rates.

In Tables 3 and 4 we present the results of our multiple regressions. In these regressions, quartiles refer to
the size of the companies included in our study, with quartiles 1 through 4 corresponding to the firms from smallest
to largest respectively. The independent variables included are the stock price volatility, market capitalization of the
firm, a crisis period dummy that equals one if the study year is 2007, 2008 or 2009, a financial sector dummy that is
1 if the firm belongs to the financial sector, and finally international capacity of the firm as measured by the
geographic segments they serve. The dependent variable in Table 3 is the debt in liabilities/assets ratio, and in Table
4 it is the short term borrowing rate of the company. Please note that since the short term borrowing rate is an annual
variable whereas debt in liabilities/assets is a quarterly variable we have more observations in Table 3 than in Table
4.

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In Table 3 we show that the debt to assets ratio is decreasing with volatility for all quartiles except for the
largest firms where it is increasing. Additionally the crisis period dummy is negative for all size groups showing that
all quartiles deleveraged during the financial crisis period when idiosyncratic risk was increasing. The financial
sector dummy shows us that for each size quartile the debt to assets ratio of financial firms were higher indicating
the higher leverage of financial firms.

In Table 4 we show that the short term borrowings rate is decreasing in volatility showing that firms try to
deleverage when their stock price volatility increases and hence they are able to take advantage of more
advantageous borrowing rates. We only find that during the crisis period the borrowing rate of small sized firms
increased but we do not find a statistically significant result for other size quartiles. Similarly, the coefficient for the
financial sector dummy is negative for all size quartile but it is only statistically significant for quartile 2. The
market capitalization coefficient is negative for each quartile showing that within each group as the firms got larger
their borrowing rate decreased, which is also expected as smaller firms typically pay higher borrowing rates.

In Table 5 we present the results for the equity to assets ratio. In Panel A we have the results for the whole
sample and in Panels B and C we present the results for the largest quartile. Consistent with our other findings the
equity to assets ratio is increasing with stock price volatility (as firms deleverage) and this finding is reinforced
during the crisis years. However financial sector firms have a lower equity to assets ratio and geographically
diversified firms also have lower equity to assets ratios.

Our analysis shows that firms debt ratio is decreasing (and equity ratio is increasing) in idiosyncratic
volatility across different size quartiles. This is consistent with financial accelerator; as idiosyncratic risk increases
borrowing costs rise leading to less borrowing and deleveraging. This effect is pronounced for smaller and mid-size
firms. Further, we find that this effect is reinforced during the financial crisis. Financial firms hold more debt
compared to other industries, but they also deleveraged during the financial crisis. We find that the short term
borrowing rate is decreasing in stock price volatility as we hypothesized, however during the financial crisis period
there was no further decline in short term borrowing rates.

CONCLUSION

In this study we investigate the relationship between idiosyncratic risk and the debt ratios and short term
borrowing rates of 500 large-capitalization and mid-capitalization publicly traded firms during the period of 1985-
2009. Financial economics literature establishes that there is a link between stock price volatility of a firm and its
capital structure decisions as the firms try to steer away from debt especially during periods of financial downturns.
We test this hypothesis by isolating the financial crisis years of 2007-2009 in our sample.

We find that there is a negative relationship between increased stock price volatility and the debt to equity
ratio of a company for all size groups except for the largest companies. Further, the above described relationship is
reinforced during the financial crisis as all firms deleverage further in response to elevated idiosyncratic risk. Our
results are consistent with the financial accelerator framework; as idiosyncratic risk increases firms deleverage in an
attempt to decrease their borrowing costs, and through this mechanism they are able to make it through economic
downturns. We also show that financial firms hold more debt compared to other non-financial firms, but financial
firms also deleveraged during the financial crisis. Furthermore, our findings provide continued evidence of the trend
in higher idiosyncratic volatility along with it economic effects, namely the firms revision of their capital structure
as higher risk-premia tilts the balance away from debt. During the financial crisis this was more than ever the case.

On the policy side of the study, there are important implications for financial supervision and regulation.
Several of the findings reinforce the importance of well-functioning capital and credit markets. While the shift from
debt to equity (and vice versa) by firms shows efficiency, it can prove disruptive if such shifts add further
uncertainty to the capital markets, or if such shifts becomes more difficult due to market imperfections. The fact that
the cost of funding advantage of financial firms reversed during the crisis highlights the level of heightened risk
perceived among credit originators. This sense of concern is reinforced by higher relative idiosyncratic volatility of
the largest firms. These factors present a clear case for strong supervision against multifaceted underlying systemic
risk.

This paper also opens the door into revisiting the broader question of the Great Moderation and the secular
trend in firm-level risk. In other words, is the backdrop of a more stable general economy is gone, or is the unfolding
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The Journal of American Academy of Business, Cambridge * Vol. 19 * Num. 2 * March 2014 92
of the housing and financial markets crises a hiatus? And as far as the ever-larger idiosyncratic volatility in equity
prices, the question is whether it may have accelerated relative to its trend? Answers to these important questions
most certainly merit further academic research.


Table 1a. Summary Statistics (Whole Sample)
Units Nonfin Financial Nonfin Financial Nonfin Financial Nonfin Financial
MarketCapitalization ThousandUSD 2,044 1,723 4,349 4,352 8,404 8,663 38,069 40,887
Debt(inliabilities)/Assets %points 3.88 5.09 4.02 5.71 3.96 5.91 4.92 7.24
Shorttermborrowingrate %points 6.25 4.29 7.52 2.15 8.77 3.64 15.77 7.01
Standarddeviationofreturns %points 2.87 2.70 2.31 2.19 2.19 2.04 1.98 2.31
Geographicregions number 2.10 2.12 2.09 2.15 2.10 2.19 2.32 2.36
1stquartile 2ndquartile 3rdquartile 4thquartile
SummaryStatistics(averages)




Table 1b. Summary Statistics (Financial Crisis, 2008)
Units Nonfin Financial Nonfin Financial Nonfin Financial Nonfin Financial
MarketCapitalization ThousandUSD 2,369 2,685 6,817 6,908 15,082 14,957 69,241 61,322
Debt(inliabilities)/Assets %points 4.00 4.25 3.95 5.22 3.56 4.89 3.75 5.71
Shorttermborrowingrate %points 4.37 3.24 1.34 1.45 2.35 2.48 3.34 2.40
Standarddeviationofreturns %points 6.04 4.95 5.07 3.66 4.36 3.39 4.10 3.06
Geographicregions number 2.14 2.12 2.11 2.11 2.10 2.22 2.39 2.42
1stquartile 2ndquartile 3rdquartile 4thquartile
SummaryStatistics(averages)




Table 2. Whole Sample (All Stocks, 1985-2009)
Panel A: Dependent Variable: Debt (in Liabilities)/Assets
Coefficient St. Error T-Value Prob > |t|
Num of obs = 43339
Stock Volatility -0.075486 0.024674 -3.06 0.002

Panel B: Dependent Variable: Equity/Assets
Coefficient St. Error T-Value Prob > |t|
Num of obs = 43365
Stock Volatility 0.8912095 0.069306 12.86 0

Panel C: Dependent Variable: Short Term Borrowing Rate
Coefficient St. Error T-Value Prob > |t|
Num of obs = 1762
Stock Volatility -1.475762 0.19585 -7.54 0

Panel D: Dependent Variable: Debt (Long Term)/Assets
Coefficient St. Error T-Value Prob > |t|
Num of obs = 43339
Stock Volatility -0.126132 0.05059 -2.49 0.013





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Table 3. Quartile Analysis, Dependent Variable: Debt (in Liabilities)/Assets
Quartiles refer to the size of the companies included in our study, with quartile 1 containing the smallest companies and quartile 4 containing the
largest companies. The independent variables included in this study are the stock price volatility, market capitalization of the firm, a crisis period
dummy that equals one if the study year is 2007, 2008 or 2009, a financial sector dummy that is 1 if the firmbelongs to the financial sector, and
finally an international dummy that equals oneif the company has international sales.
Panel A: Quartile 1 Coefficient St. Error T-Value Prob > |t|
Num of obs = 9156
Volatility -0.182885 0.051417 -3.56 0
Market Cap -2.61E-06 4.12E-07 -6.33 0
Crisis Period -0.023625 0.004357 -5.42 0
Financial Sector 0.0074714 0.001723 4.34 0
International -0.01075 0.004405 -2.44 0.015
Panel B: Quartile 2 Coefficient St. Error T-Value Prob > |t|
Num of obs = 9936
Volatility -0.274772 0.055645 -4.94 0
Market Cap -2.24E-06 1.98E-07 -11.36 0
Crisis Period -0.007824 0.003959 -1.98 0.048
Financial Sector 0.0072809 0.001539 4.73 0
International 0.0005602 0.003987 0.14 0.888
Panel C: Quartile 3 Coefficient St. Error T-Value Prob > |t|
Num of obs = 10480
Volatility -0.303847 0.064546 -4.71 0
Market Cap -1.76E-06 1.43E-07 -12.35 0
Crisis Period -0.030105 0.005512 -5.46 0
Financial Sector 0.0157894 0.002013 7.84 0
International -0.002668 0.004317 -0.62 0.537
Panel D: Quartile 4 Coefficient St. Error T-Value Prob > |t|
Num of obs = 10837
Volatility 0.6351048 0.072746 8.73 0
Market Cap 1.14E-07 1.39E-08 8.18 0
Crisis Period -0.034149 0.005436 -6.28 0
Financial Sector 0.0320958 0.002047 15.68 0
International 0.043577 0.002925 14.9 0

Table 4. Quartile Analysis, Dependent Variable: Short Term Borrowing Rate
Quartiles refer to the size of the companies included in our study, with quartile1 containing the smallest companies and quartile 4 containing the
largest companies. The independent variables included in this study are the stock price volatility, market capitalization of the firm, a crisis period
dummy that equals one if the study year is 2007, 2008 or 2009, a financial sector dummy that is 1 if the firmbelongs to the financial sector, and
finally an international dummy that equals oneif the company has international sales.

Panel A: Quartile 1 Coefficient St. Error T-Value Prob > |t|
Num of obs = 391
Volatility -1.32669 0.199897 -6.64 0
Market Cap -1.65E-05 1.59E-06 -10.4 0
Crisis Period 0.192714 0.070433 2.74 0.007
Financial Sector -0.03218 0.015335 -2.1 0.036
International -0.01364 0.009765 -1.4 0.163
Panel B: Quartile 2 Coefficient St. Error T-Value Prob > |t|
Num of obs = 468
Volatility -0.87421 0.318312 -2.75 0.006
Market Cap -1.1E-05 1.03E-06 -10.67 0
Crisis Period -0.03695 0.031047 -1.19 0.235
Financial Sector -0.01994 0.010363 -1.92 0.055
International -0.01325 0.010281 -1.29 0.198
Panel C: Quartile 3 Coefficient St. Error T-Value Prob > |t|
Num of obs = 407
Volatility -1.12597 0.560184 -2.01 0.045
Market Cap -6.83E-06 1.94E-06 -3.53 0
Crisis Period -0.10535 0.144317 -0.73 0.466
Financial Sector -0.01634 0.032124 -0.51 0.611
International -0.01956 0.021044 -0.93 0.353
Panel D: Quartile 4 Coefficient St. Error T-Value Prob > |t|
Num of obs = 495
Volatility -0.65992 0.375787 -1.76 0.08
Market Cap -1.02E-06 2.64E-07 -3.85 0
Crisis Period -0.06577 0.094118 -0.7 0.485
Financial Sector -0.01002 0.023233 -0.43 0.666
International 0.017697 0.008801 2.01 0.045
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Table 5. Dependent Variable: Equity/Assets
Quartiles refer to the size of the companies included in our study, with quartile 1 containing the smallest companies and quartile 4
containing the largest companies. The independent variables included in this study are the stock price volatility, market capitalization of
the firm, a crisis period dummy that equals one if the study year is 2007, 2008 or 2009, a financial sector dummy that is 1 if the firm
belongs to the financial sector, and finally an international dummy that equals one if the company has international sales.

Panel A: Whole Sample Coefficient St. Error T-Value Prob > |t|
Num of obs = 43365
Volatility 0.8912095 0.069306 12.86 0



Panel B: Quartile 4 Coefficient St. Error T-Value Prob > |t|
Num of obs = 11678
Volatility 0.9449259 0.134491 7.03 0



Panel C: Quartile 4 Coefficient St. Error T-Value Prob > |t|
Num of obs = 11342
Volatility 2.385259 0.174517 13.67 0
Market Cap 1.41E-07 3.31E-08 4.26 0
Crisis Period 0.1391771 0.01306 10.66 0
Financial Sector -0.068474 0.004908 -13.95 0
International -0.05125 0.007037 -7.28 0

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